Investors who have owned securities for many years can accumulate significant unrealized gains. Selling those investments to reposition a portfolio can trigger capital gains taxes. In certain circumstances, a Section 351 exchange, sometimes called a 351 exchange, can allow investors to contribute appreciated investments to a newly formed exchange-traded fund (ETF) in exchange for shares of that ETF without recognizing gain or loss at the time of the exchange. 1,2
How Does a 351 Exchange Work?
Section 351 of the Internal Revenue Code generally provides for nonrecognition of gain or loss when one or more people transfer property to a corporation solely in exchange for its stock and, immediately after the exchange, the transferors collectively control the corporation.1 For this purpose, control generally requires ownership of at least 80% of the corporation’s voting power and at least 80% of the shares of its other classes of stock.2
In an ETF-related 351 exchange, multiple investors can contribute eligible securities to a newly created ETF in return for ETF shares. When the transaction meets the applicable requirements, investors do not recognize capital gains simply because they contributed appreciated securities. 1,2
That does not mean the embedded tax liability disappears. The transaction generally preserves the existing tax basis rather than resetting it, effectively deferring recognition of the gain until a later taxable disposition.3
See more: Defining the New “Platform Value”: Keeping Your RIA Attractive, Whether You’re Buying or Selling
Why Are 351 Exchanges Used?
A 351 exchange can provide a way to restructure an appreciated taxable portfolio without first selling all of its underlying securities and immediately recognizing the associated gains.
For example, an investor could own a portfolio of individual stocks that has appreciated substantially over time. If that portfolio meets the requirements for a qualifying exchange, eligible securities may be contributed to an ETF rather than sold for cash. In return, the investor receives shares representing an interest in the ETF.
What Are the Potential Benefits of a 351 Exchange?
When properly structured, a 351 exchange may offer several potential benefits:
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Tax deferral: Appreciated securities can be exchanged without recognizing capital gains at the time of the qualifying transaction.1
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Portfolio transition: Investors can move from a collection of individual securities to an ETF structure without first liquidating the entire portfolio.
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Ongoing market exposure: Because securities are exchanged rather than sold for cash, investors can remain invested through the transition.
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Simplification: Multiple individual holdings can ultimately be represented by shares of a single ETF.
What Are the Requirements and Risks of a 351 Exchange?
Section 351 exchanges are subject to specific tax rules. Importantly, the tax code generally excludes transfers to an investment company when the transfer results in diversification.1 Treasury regulations provide additional rules for determining when a transfer results in diversification.4
Consequently, portfolios contributed in an ETF-related Section 351 transaction generally must already satisfy applicable diversification requirements. Requirements include limits on how much of the portfolio can be represented by a single issuer or a small number of issuers.4
Not every portfolio, security, ETF, or transaction will qualify. Investors must also consider the investment strategy and risks of the ETF they receive, along with transaction-specific tax consequences.
A 351 exchange can be understood as a specialized tax-deferred method of exchanging eligible property for corporate shares, not a way to eliminate taxes altogether.
Sources
The views expressed represent the opinion of Sequoia Financial Group. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Sequoia believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Sequoia’s view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements. Investing in equity securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. Past performance is not an indication of future results. Investment advisory services offered through Sequoia Financial Advisors, LLC, an SEC Registered Investment Advisor. Registration as an investment advisor does not imply a certain level of skill or training.
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